The Swiss Franc: Markets 1, Central Banks 0
In this world of central bank guarantees, bank bailouts, central bank manipulation of interest rates, trillion-dollar quantitative easing (QE) campaigns, and capital controls, one could be forgiven for believing that central banks are more powerful than markets. This is a fallacy. They aren’t.
So this week, when the Swiss National Bank (SNB) broke the Swiss franc’s cap (of 1.20) to the euro, it demonstrated that the SNB had conceded central bank power to market power. Why do I say that? Wasn’t it just the SNB’s response to market conditions? No. The move was inevitable. It was simply a matter of time.
To understand this, we must first acknowledge and accept that there is but one global, albeit disjointed, monetary system. Monetary policies by one central bank — especially large ones like the European Central Bank (ECB) — can and do impact monetary policies in other countries, especially smaller ones like Switzerland. Back in 2009–2010, when the European sovereign debt crisis first reared its ugly head, it created a massive amount of capital flight out of the eurozone. So, many investors, banks, corporations, etc., chose to put their money in Switzerland, seeing the Swiss franc (CHF) as a safe haven, which in turn drove up the value of the Swiss franc. As illustrated in the following graph, the franc appreciated from approximately 1.6 francs per euro before the crisis to about 1.05 francs per euro between October of 2008 and August of 2011 (green shaded area).
Sources: European Central Bank, Quandl, CFA Institute.
To stem the capital inflows into Switzerland, the SNB placed a cap on the CHF-EUR exchange rate at 1.20 francs per euro in September of 2011. In effect, the SNB then linked their monetary policy to the ECB. Mechanically speaking, the cap meant that the SNB had to print francs and purchase foreign currencies to offset the market forces.
However, in September 2014, the ECB cut rates and also announced a new program to purchase bonds — further easing monetary policy. Due to the SNB’s cap on the exchange rate, the ECB’s announcement meant that the Swiss bank faced a choice: either accelerate the printing of francs to offset the incremental monetary stimulus from the ECB, or exit the cap and return to market exchange rates. After nearly three years, the Swiss are raising the white flag. Market forces win.
There are two primary ramifications from these events. First, a powerful meme that central banks are all-powerful compared to markets has once again been shattered. Just because central banks can tweak market prices at their discretion does not mean that central banks can permanently control markets. And the tipping point creates massive dislocations as central banks shift from manipulated exchange rates to market exchange rates (and vice versa).
Moreover, these sudden, large shifts in policy are not captured well in statistical analysis. The relatively mundane day-to-day variations in prices during “normal” times tend to overwhelm the few large regime shifts in quoted prices.
The immediate effect is that anyone (e.g., Swiss companies) who has costs or liabilities in francs and revenues or assets in euros or other currencies is at risk. Few were prepared for such a dramatic shift in currencies. The 30% move in the franc will no doubt hobble the financial profile of many Swiss companies. The higher franc lowers the cost of imports into Switzerland and, for the moment, reduces the inflationary pressures on consumer products brought about by the massive money printing of the SNB. However, the influx of capital bids up prices of local assets in Switzerland, like real estate and bonds, which are extraordinarily expensive already.
These actions also impair trust between the markets and governments. Just days earlier, Thomas Jordan, the president of the SNB, affirmed the bank’s commitment to the cap. Only three days later, he said, “We came to conclusion that it’s not a sustainable policy.” You don’t say?
In the final analysis, the SNB actions ultimately demonstrate the difference between currency and money. The SNB can of course control currency in circulation and regulate the banking system (which affects the money supply), but the value of that currency is determined by people. You and me. How we buy that currency, how we sell that currency, and how we spend that currency. And we just told the world’s central bankers that the appropriate value of the franc is a lot more than 1.20 euro. And it isn’t because we like the franc that much. How could we? It’s because we dislike the euro even more. There wasn’t any other way. Central banks 0. Markets 1.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Photo credit: ©iStockphoto.com/Anna Bryukhanova